As 2007 drew to a close, many Americans eagerly anticipated their upcoming retirement dates. After all, roughly 10,000 Baby Boomers retire daily. But by the end of 2008, many of the people who did decide to retire that year probably wished they hadn’t.

The S&P 500 fell 37% over the course of the year, significantly eroding their retirement savings and digging them into a hole that would be tough to climb out of.

This experience illustrates the perils of sequence of returns risk, which occurs when the market’s returns at a specific time are unfavorable, even if that volatility averages out into favorable returns during the long term.

This type of risk is particularly devastating to retirees when it occurs early in retirement. That’s why people need to be aware of a number of factors as they contemplate retirement, including how sequence of returns risk works, the market backdrop during the run-up to retirement and retirement income strategies that can counteract this risk.

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How This Risk Factor Works

Both investors and advisers tend to consider market returns in terms of averages. Averages smooth out volatility and show how investments perform over time.

Investors usually are advised to ignore market volatility and focus on long-term returns. Generally, this is a good strategy, because moving in and out of stocks based on short-term ups and downs in the market can put your money at more risk. That’s because most investors trying to time the market end up missing gains when the market recovers.

However, individual investments and portfolios don’t move up and down based on market averages. They rise and fall based on daily market movements. That’s where this type of risk comes in. An investment portfolio must have time to benefit from long-term gains, especially in retirement. Research shows that when investment losses take place early in retirement, it can be difficult for a retiree’s portfolio to recover.

Sequence of Returns Example

Let’s return to the example of the market drop in 2008 to illustrate how the order in which investment returns occur impacts an actual investment portfolio. Consider the example of a retired couple with $1 million in investments, with 60% of that invested in the stock market and 40% in the bond market. We’ll use the S&P 500 for the stock market portion and the S&P U.S. Aggregate Bond Index as a proxy for the bond market. When the market falls early in retirement, this couple takes a nearly $200,000 hit right off the bat.

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Jan. 1, 2008 balance

2008 return

Dec. 31, 2008

60% stock market

$600,000

-37.00%

$378,000

40% bond market

$400,000

5.70%

$422,800

Total

$1 million

$800,800

4% yearly withdrawal

$32,032

Let’s contrast Table 1 with a scenario in which favorable returns, Table 2, occurred instead. These favorable returns work in a retiree’s favor and manifest themselves in a situation where the stock market climbed in the first year of retirement. This table shows how the portfolio would have performed if the stock market portion rose and the bond market portion declined by the same percentages as in the earlier example.

Initial balance

Return

End balance

60% stock market

$600,000

37.00%

$822,000

40% bond market

$400,000

-5.70%

$377,200

Total

$1 million

$1,199,200

4% yearly withdrawal

$47,968

The difference between the portfolios is nearly $400,000, or 40%. The impact on a 4% withdrawal rate from that portfolio, used for retirement income spending, is startling. The couple in the first example has $32,032 to spend, while the couple in the second example has $47,968 to spend, a nearly $16,000 difference.

Timing Your Retirement

Since there aren’t any crystal balls available, people can’t time the market and retire at just the right moment. However, there are some strategies financial advisers experienced with retirement income planning can implement to mitigate sequence of returns risks.

1. Planning for market downturns

Investors and retirement savers need to understand market dynamics. Anyone on the brink of retirement today is in a situation where the bull market entered its ninth year on March 9, which ranks as the second-longest bull market on record.

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That doesn’t mean the market is ripe for a fall, but the length of the bull market is something to keep in mind. At times like these, those close to retirement should consider re-allocating assets toward investments that can provide guaranteed income in retirement and away from those that might fall in value when the bull market eventually ends.

3. Diversify your portfolio

Diversifying a portfolio among various asset classes helps hedge against the risk of a falling stock or bond market. For example, moving investments into sources of guaranteed income, such as annuities*, avoids losing investment value and income should the stock or bond market fall, providing less risk and a higher level of income.

4. Fill up your buckets

Finally, many retirement income financial advisers employ a “bucket” approach that allocates specific “buckets” of savings for specific purposes. Using that approach, a certain amount of money is set aside for ongoing income, future health care expenses, emergency expenses, capital expenses (a new car, for example) and other needs. Funds tagged for ongoing income, for instance, then would be placed in an investment that would be less subject to market risk and more likely to provide an ongoing income stream.

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The Final Word for People Nearing Retirement

Consider your current retirement income plan and ask yourself this: Will it hold up against the pressure of sequence of returns? Consider incorporating financial vehicles that may help reduce the risk during your retirement.

Written in collaboration with Amy Buttell.

*Guarantees, including optional benefits, are backed by the claims-paying ability of the issuer, and may contain limitations, including surrender charges, which may affect policy values.

Securities and advisory services offered through Client One Securities LLC, member FINRA/SIPC and an Investment Adviser. Sawyer Wealth Management and Client One Securities are not affiliated. Member FINRA & SIPC.

Charles W. Sawyer Jr. is the managing partner and founder of Sawyer Wealth Management and has been providing financial planning services for more than 30 years. His primary focus is working with pre-retirees, retirees and their families in the areas of financial planning and estate planning.